Court Ruling Against Banks Lets MBIA Benefit From Splitting Up

March 7, 2013

High & Low Finance

By FLOYD NORRIS

Some people are inherently more deserving of sympathy than others.

Imagine, for a moment, what a court might say if state regulators allowed an insurance company, facing huge losses because of Hurricane Sandy, to separate itself into two companies. One, thinly capitalized and in clear danger of not being able to pay all claims, would insure the areas hit by the hurricane, like the beach towns of New Jersey and the Rockaway area of Queens. The other, with plenty of capital, would carry all the policies that were not likely to have large claims.

Of course, no regulator would do that. And any court confronted with such an act would search for reasons to overturn it.

Now imagine an insurance company split up with the clear purpose of discriminating against a set of policyholders who were the subject of overwhelming public scorn rather than public sympathy — perhaps the people who had caused the catastrophe that led to the losses.

Just such a case was decided this week. And the state regulator’s decision was upheld by a judge who concluded that the regulator was entitled to the widest possible latitude in making its decisions. If the regulator had not bothered to verify calculations in the insurance company’s financial projections, and those calculations turned out to be wildly inaccurate, that was fine with the judge.

That case did not concern a hurricane, of course. It instead concerned the financial storm that sent the world into recession and led countries to bail out the banks that had made bad loans that led to the disaster.

The insurance company was MBIA, a company that prospered insuring municipal bonds, almost all of which were safe anyway. It then made the huge mistake of deciding to also insure structured financial products, like collateralized debt obligations and commercial mortgage-backed securities. It did little investigation of what actually backed those securities, explaining later that its low fees made such investigations too expensive. Instead it relied on the ratings agencies and on the banks that had put the securities together.

That reliance was misplaced, and MBIA is now in danger of being unable to pay claims on those securities.

In 2009, Eric Dinallo was superintendent of the New York State Insurance Department, which approved the division of MBIA.

Don Heupel / Associated Press

In 2009, with the blessing of its regulator, the New York State Insurance Department, MBIA decided to split in two. On one side, fully protected, were the insurance policies issued to muni bond investors in the United States. On the other side were the structured finance policies, which would mostly benefit the banks that had bought such products. A group of banks sued to overturn the breakup.

Justice Barbara R. Kapnick of the New York State Supreme Court — a trial court despite the lofty title — listened to lawyers argue for 13 days over whether the case should proceed to trial. She decided there was no reason for a trial. The insurance department had wide latitude to approve the split with or without much investigation, and she would not second-guess it.

Anyone from the Securities and Exchange Commission who might read Justice Kapnick’s opinion will be envious. The S.E.C. has to contend with a court — the United States Court of Appeals for the District of Columbia Circuit — that instinctively throws up roadblocks to any rule the commission passes. The S.E.C. jumps through whatever hoops the court established in its last decision but, somehow, it never quite manages to live up to what the D.C. circuit requires in its next ruling.

Justice Kapnick, on the other hand, is not bothered by the fact that the state insurance department relied on MBIA financial filings that turned out to be very inaccurate — not just later but at the time that the filings were made.

The banks, she said, “fail to provide any legal authority to support their argument that this court can annul the department’s decision based on claims that MBIA concealed or withheld potentially damaging information” from the department.

She quotes from a deposition by Michael Moriarty, the deputy superintendent of the department and the man who signed the letter approving the split. When considering MBIA’s request, he said, “the department did not, nor do they usually, verify the financial condition of a company.” Since that was the policy, the judge concluded she had no authority to question it.

The New York Insurance Department has since been combined with the state banking regulator in a new body, called the Department of Financial Services, and that body seems to be very worried about MBIA’s ability to meet its obligations in the structured finance unit.

An interest payment that MBIA owed on a junior security it had sold to investors was not paid in January, because the department would not allow it.

Jay Brown is MBIA’s chief executive.

MBIA

MBIA’s structured finance arm has been able to make large payments to policyholders only by borrowing $1.6 billion from its municipal insurance unit, but the regulator is now refusing to approve more loans. That meant that MBIA could not complete an arrangement it made with an unnamed bank. That would have allowed the insurer to settle all future claims that bank might have for an upfront payment. For the bank, as for others that reached similar deals earlier that were approved, the lure was the promise of getting something before the unit went broke.

In its annual report filed last week, MBIA said that the regulator might commence a “rehabilitation or liquidation proceeding.” Jay Brown, MBIA’s chief executive, told investors in a conference call that he did not think such a move was probable, but he said it largely depended on the company’s ability to cut a deal with Bank of America.

That relationship is more than a little complicated. MBIA claims that Countrywide Financial, which Bank of America acquired in what may be the worst merger ever, owes it as much as $5 billion for deceiving it about structured finance products it was insuring. But Bank of America, largely through its Merrill Lynch unit, also is a major holder of MBIA insurance policies, and MBIA expects that claims will arrive soon from the bank, which is a principal plaintiff in the case Justice Kapnick ruled on.

If MBIA gets such a global settlement with the bank, it should send a letter of gratitude to Kenneth D. Lewis, the former Bank of America chief executive and the man who decided to rescue Countrywide. Had that firm been allowed to fail, MBIA would have had no hope of collecting from it, but it still would have owed the insurance payments to Merrill Lynch. It is hard to see how MBIA could have avoided collapsing.

In announcing the insurance department approval of the split in 2009, Eric Dinallo, then superintendent, stated, “This deal is fair to all policyholders — the bank counterparties and other policyholders of the structured financings and the owners and issuers of municipal bonds.” He said it was aimed at assuring that muni bond insurance would continue to be available.

The news release added, “Consistent with New York State insurance law, the New York State Insurance Department only approved the transaction after deciding that both companies would have sufficient statutory capital to meet the letter and spirit of the insurance law.”

It turns out that was wrong. The structured finance unit would have no capital on its books now if it did not assume that Bank of America will pay billions to it.

Wall Street seems to think that MBIA’s strategy will work, and that the muni bond business will keep operating even if the structured finance part goes into liquidation. The stock leapt to its highest level in a year on news of the court ruling.

The lawyer for the banks says an appeal of Justice Kapnick’s ruling will be filed, but it is at least conceivable that there will be a settlement before any appeal is decided, leaving her opinion as the final one on the case. And next time, if some other insurance company fails to be completely forthcoming when getting approval for a transaction that turns out to be disastrous for some other group of policyholders, there will be a precedent saying such conduct is just fine.